|Shares Out. (in M):||50||P/E||12.8||6|
|Market Cap (in $M):||1,187||P/FCF||NA||6|
|Net Debt (in $M):||1,385||EBIT||159||287|
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Triumph Group (“TGI”) is an aerospace supplier that is nearing the end of a significant multi-year turnaround led by Dan Crowley and his new management team. The Company recently announced it is pursuing strategic alternatives for its previously struggling Structures division now that management has restructured the segment’s operations by renegotiating or exiting multiple negative margin programs. In recent years the Structures division has masked the profitability of Triumph’s other segments and we believe the market does not yet realize the full earnings potential of Triumph should the Structures division be sold/spun while also underestimating what valuation Triumph will receive for the Structures division if a sale is successful. We believe Triumph is worth over $50 per share, representing over 100% upside from today’s share price should the Structures division be sold within the next year as we expect.
Our investment thesis is predicated upon the following:
We believe management will be able to achieve the margin targets set out on their recent February earnings call for both the Systems and Product Support segments as the benefits of the restructuring efforts begin to flow through the P&L over the next two years
The multiple should expand over time from Triumph’s historical “Structures multiple” (SPR is the comparable) to a “Systems multiple” (UTX is the comparable). Once Structures is divested, we believe the new Triumph will have significantly higher ROIC, stable topline growth and generate significant excess free cash flow, but that isn’t easily apparent using the current consolidated financials
We believe the Structures segment has been “fixed” and the margin targets set out for this segment on the February earnings call are achievable. Investors and analysts do not appreciate the negative margin impact of multiple large programs that have now all been renegotiated in the last 18 months (namely the G650, G280, E2 & Global 7500 programs). As the last negative margin programs roll off over the next 12 months, the healthy margins on existing mature programs will become apparent. The margins of the broader Structures segment will move higher just by removing the negative margin programs from the mix
The Structures assets have significant value. There are a limited number of Structures suppliers globally and very few new platforms being developed which makes organic growth difficult. Triumph has been able to recently secure content on multiple new military programs that will ramp over the next few years including the TX Trainer (a multi-decade military fighter program), the Air Force’s 767 Tanker (which begins ramping this year) and the MQ-25 among others which are all higher margin and valuable programs. While these military programs slowly ramp, the commercial programs that will remain are expected to continue stable monthly production volumes and generate positive cash flow which makes Structures attractive to a buyer
For over 20 years TGI grew steadily via acquisition of small aerospace suppliers. It did this using a HoldCo model which allowed the companies it acquired to remain independent. This model was attractive to sellers as their company would remain relatively unchanged once they joined the broader Triumph Group. It also allowed Triumph to grow aggressively via acquisition without having to pause and integrate operations. This model worked until Triumph made the decision to acquire Vought from the Carlyle Group in 2010 for $1.6 billion. At the time, Vought had approximately $1.9 billion in revenues and this acquisition more than doubled the size of Triumph while adding significant debt to the balance sheet. Post the Vought acquisition, Triumph Group reported its financials as three primary segments: Structures (mostly Vought), Integrated Systems, and Product Support. But these labels were misleading as these three segments consisted of 47 independent companies with minimal operational overlap.
Part 1: What Will the New Triumph Look Like?
Most of the recent narrative and sell side literature for Triumph relates to their Structures division which is now being divested (described in detail in Part 2 below). However, it is the highly profitable Integrated Systems and Product Support segments that do not get enough attention and make Triumph an attractive investment opportunity. Based on the press release announcing the strategic alternatives review, TGI expects to keep the Integrated Systems, Product Support and Interiors businesses going forward (together referred to here as the “RemainCo”). These assets have the potential to earn +20% EBITDA margins while generating stable and predictable free cash flow on a diversified group of commercial and military platforms. The strong cash flow profile of these businesses isn’t apparent in their current quarterly consolidated financials since the Structures segment has historically absorbed all of the cash flow these segments have generated (and more).
The largest segment that will remain is the current Integrated Systems segment. This will become the core of Triumph going forward and will generate over 50% of the RemainCo’s sales and EBITDA. The Integrated Systems segment specializes in complicated, high precision assemblies and sub-assemblies such as landing gear and helicopter rotors. Many of these parts are sole sourced from TGI and suffer from wear and tear over time, which also provides Triumph with higher margin aftermarket work, though this aspect of the business is less well known. Integrated Systems has significant intellectual property on its products and provides content on some of the largest and fastest growing aerospace platforms such as Boeing’s 737 & 787 programs or Airbus’ A320. Integrated Systems also has significant military exposure which tends to have higher margins than commercial programs (F-35, AH-64 Apache and CH-47 Chinook helicopters, etc.) According to the proxy filed in May 2018, Integrated Systems generated $163 million of unlevered free cash flow for FY2018 (proxy for most recent fiscal year not yet filed). The annual proxy is the only filing where the free cash flow for each segment has been disclosed as the management teams that lead these segments are partially compensated on cash flow generation, and this is discussed in detail as part of the annual executive compensation discussion (chart from May 2018 proxy copied below).
The Product Support segment is much smaller than Integrated Systems, but earns equally strong margins and is a potential avenue for growth going forward should Triumph decide to pursue growth via acquisition again in the future. This segment specializes in Maintenance, Repair and Overhaul (“MRO”). This segment has facilities across the globe and contracts with some of the largest fleet operators for their ongoing maintenance requirements. End demand for this segment is tied directionally with miles flown as aircraft are required to get regular maintenance by regulators. According to the proxy filed in May 2018, Product Support generated $44 million of unlevered free cash flow for FY2018 (chart from May 2018 proxy copied below).
Lastly, the RemainCo will have Interiors. This segment is less well known as it is currently embedded within the broader Structures segment and wasn’t really discussed until recent earnings calls. The press release indicates that management intends to keep this asset and we don’t know much about it (yet). Management has communicated to the sell side that this business is roughly the same size and profitability as Product Support. Given management has decided to keep this business we can only assume it has an attractive ROIC and similarly attractive free cash flow profile (in the numbers below I assume Interiors is a copy of Product Support for now).
What is the earnings power of RemainCo?
The numbers below are based on the most recent quarterly investor presentation where management provided longer-term margin targets by segment for the first time as well as new pro forma financials to adjust for the small divestitures that closed in calendar Q1’19. We are assuming Interiors is the exact same as Product Support for now. Combining the three segments and using management’s margin targets for FY2021 (FYE 3/31 or ~2 years away) allows us to easily piece together what the RemainCo will look like.
The following slides are copied directly from the most recent February quarterly investor presentation. The assumptions that require management clarification are listed below while others such as segment D&A and Amortization of Intangibles for future years can be found in the 10-K. Key assumptions:
We are assuming corporate overhead for the RemainCo is equal to 3% of total sales (i.e. some corporate overhead is tied to the Structures segment and those costs will leave with that segment while others will stay behind with RemainCo)
All current pension related items are going with Structures as our understanding is that most of the pension is tied to that segment based on prior disclosure but given Interiors is embedded within Structures, a small amount of pension may stay with RemainCo
Interest expense will vary based on proceeds received for Structures division but you will see in the sensitivity below that even if they received nothing for the Structures division and interest expense remains at current levels (~$100mm), the stock is still worth materially more than where it is today
Current NOLs will stay with RemainCo (and Structures will likely be sold at a loss, potentially increasing the NOLs, therefore RemainCo will not pay cash taxes in the near term)
Taking these numbers above and combining them into a pro forma income statement for the RemainCo is very straightforward. The segment free cash flow disclosure in the proxy statement (copied above) gives us a good sanity check that confirms the free cash flow for RemainCo should be over $200mm or $4.00 per share (~20% free cash flow yield at today’s price of $23.78 for a top tier aerospace supplier).
What Multiple Should RemainCo Trade At?
Historically Triumph has traded in line with its Structures peers (SPR and TXT are highlighted in orange below) since Structures was roughly half of TGI’s revenue (though it generated much less than half of EBIT). Given the majority of RemainCo going forward will be tied to Integrated Systems, its closest peers are likely Hexcel (HXL) or United Technologies (UTX) (highlighted in yellow). We are assuming TGI initially trades at 15x EPS which is slightly below peer levels given it is not pure Systems company, though over time we expect it to trade closer to 18x given the free cash flow profile.
Aerospace Comparables as of 4/30/19
Target Share Price
Combining the two and sensitizing both EPS and PE multiple gives us a range of outcomes where the stock price is materially higher than today in all cases. We have sensitized the EPS given the unknowns around the ultimate price RemainCo will receive for the Structures assets (i.e. how much debt gets paid off) and given we do not know with certainty what an appropriate corporate expense level will be.
The most important takeaway from the sensitivity analysis below shows you that even if Triumph were to “give away” the entire Structures division like they did with the struggling Global 7500 program in January and interest expense remained at current levels (leaving EPS at the lower end of the sensitivity range), the stock would still be worth much more than where it is today if the market is simply willing to apply a “normal” multiple to TGI once the Structures assets are removed. That being said, we believe Triumph will receive significant value for Structures for the reason’s laid out below.
Part 2: What is Structures Worth?
Post the Vought acquisition, Triumph’s stock reacted very positively and went steadily higher over the next few years. However, behind the scenes things quickly began to sour at Vought (now known as Structures) and it soon became evident that some of Vought’s major platforms were nearing the end of their life sooner than expected due to falling demand (Boeing’s 747 for example). A depressed business jet market, driven by a glut of used inventory, also caused Gulfstream to slow production on its G450 & G550 models and lastly, the large C-17 Globemaster military transport plane reached end of life when the military decided it had enough of those massive planes. These programs were some of Triumph’s largest and most profitable programs given the amount of content TGI produced for each plane and as well as how mature each program was (they were fully up the learning curve and earning healthy margins). Taken together, this meant revenue and cash flow at Triumph’s Structures segment were at risk of collapsing.
Given aerospace has multi-year backlogs, management could see some of this coming. They aggressively bid for content on any new program that became available (there weren’t many). TGI’s experience with major wing structures as well as business jets allowed it win major new content on the new Embraer E2 and Bombardier’s Global 7500 programs (then called the Global 7000). They also acquired two struggling Gulfstream business jet programs from Spirit (the programs were so bad that Spirit paid Triumph to take the G650 and G280 programs.) If everything went to plan, the legacy programs would fund the development of the new E2 and Global 7500 programs before volumes stepped down and management would be able to turnaround the G650 and G280 programs using their prior expertise on other Gulfstream programs. This would allow Structures revenue to stabilize and continue to generate significant cash flow for Triumph well into the 2020s.
Unfortunately things did not go according to plan. Volumes on existing programs dropped faster than expected. Monthly production volumes on the 747, 777, C-17, A330 and Gulfstream G450/G550 programs all fell concurrently causing revenue, EBITDA and free cash flow to step down materially. At the same time, the E2 and Global 7500 development programs were taking longer and burning a lot more cash than initially planned, leaving TGI in a position of declining EBITDA just as cash flow needs for the E2 and Global 7500 were growing. If something wasn’t done, TGI would face a significant liquidity crunch.
In 2015, the severity of the situation was becoming apparent to Triumph and they sought out a new CEO that could restructure the Company, turn around operations and get Triumph out of the penalty box with its major OEMs. Dan Crowley was appointed in January 2016, and he set out an aggressive 3-year turnaround plan. Dan set out to blow up the prior HoldCo model, consolidate operations, significantly cut headcount, divest non-core assets and improve operations and quality so sales could begin growing again. He hired Jim McCabe as CFO who had significant turnaround and restructuring experience and they replaced the entire upper management team across all three segments. Together the new team set out to “fix” Triumph by consolidating operations and streamlining the supply chain. This turnaround that the new CEO laid out when he arrived over three years ago is now largely complete, and the physical transformation is evident based on the most recent quarterly investor presentation (copied below). However, the real key to the turnaround was stopping the cash burn on a limited number of “problem projects” that were burning cash, namely the E2, Global 7500, G280, G650 and 747 programs, though this wasn’t apparent at first.